Naked Swaps Crackdown in Europe Rings Hollow Without Washington

March 11 (Bloomberg) — European politicians and regulators could initiate a continent-wide ban on speculative trading of sovereign credit-default swaps tomorrow. Making it stick without the Americans won’t work.

New York and London dominate swaps trading, and both have resisted greater regulation. Last year, U.S. regulators and Congress rejected a proposed ban on buying credit-default swaps without owning the underlying debt. Adair Turner, chairman of the U.K. Financial Services Authority, said yesterday that these so-called naked swaps weren’t the “key driver” of the Greek debt crisis and it would be wrong to rush to ban them.

“You need to get the U.S. on board, otherwise the effect will be minimal because trading will simply move elsewhere,” said Jan Hagen, head of the financial services group at the European School of Management and Technology in Berlin. “A ban would allow European politicians to tell voters at least they’re doing something.”

The European Union’s top regulatory official, European Commission President Jose Barroso, said March 9 that the 27- nation bloc will consider banning “purely speculative naked” credit-default swaps after German Chancellor Angela Merkel and French President Nicolas Sarkozy called for a crackdown on derivatives trading to prevent a rerun of the Greek crisis.

Papandreou, Obama

Greek Prime Minister George Papandreou, who met this week in Washington with U.S. President Barack Obama and U.S. Treasury Secretary Timothy F. Geithner, has been campaigning against “unprincipled speculators,” saying they threaten a new global financial crisis. In an interview with PBS NewsHour, Papandreou compared his country’s predicament to that of short-sellers targeting Lehman Brothers Holdings Inc., saying any country could become the next “target.”

Obama made no statement after the meeting. His spokesman, Robert Gibbs, said the administration believes the European Union should take the lead in dealing with the Greek crisis.

U.S. and U.K. regulators, who imposed temporary bans on short-selling financial stocks after Wall Street executives led by John Mack, CEO at Morgan Stanley at the time, called for emergency measures following the bankruptcy of Lehman Brothers in September 2008, never halted trading of naked credit-default swaps. Geithner has said he doesn’t think such a measure would have merit.

“My own sense is that banning naked swaps is not necessary and wouldn’t help fundamentally,” Geithner told lawmakers on March 26, 2009. “It’s too hard to distinguish what is a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome.”

‘Implemented Immediately’

A Europe-wide ban on naked swaps “could be implemented immediately” under the EU’s Market Abuse Directive, said Simon Gleeson, financial-regulatory partner at Clifford Chance LLP in London. Such action would be tested in the European Court of Justice in Luxembourg, with a verdict likely “to take six years,” he said.

For now, talk by Merkel and others of bans and tough regulation is designed “to frighten the hedge funds off the trades,” Gleeson said.

EU finance ministers meet March 16 to discuss a ban, and leaders of the Group of 20 nations will discuss the issue in June. Without simultaneous restrictions in the U.S., a European ban “wouldn’t be very effective,” Nicolas Veron, senior economist at Bruegel, a Brussels-based research organization, said in a telephone interview.

Trading Is Mobile

“Trading would just migrate to countries where no ban exists,” he said. “If you tell your own banks, ‘I’ll crush you if you trade in other countries,’ you would put your domestic banks at an economic disadvantage to others.”

Credit-default swaps are derivatives that pay the buyer face value if a borrower — a country or a company — defaults. In exchange, the swap seller gets the underlying securities or the cash equivalent. Traders in naked credit-default swaps buy insurance on bonds they don’t own. The contracts trade in over- the-counter deals, leaving each side exposed to the risk their partner will default.

Swaps are private contracts and most aren’t traded through clearinghouses, making it difficult for regulators to police a ban and for politicians to define which trades are purely speculative.

“There’s no framework for that to be done right now,” said Brian Yelvington, head of fixed-income strategy at Greenwich, Connecticut-based broker-dealer Knight Libertas LLC and a former swaps trader.

Regulation Fizzles

While the U.S. Congress is discussing legislation that would require some derivatives be backed by clearinghouses and traded on regulated platforms, talk about banning naked credit- default swaps has fizzled.

In July 2009, House Financial Services Committee Chairman Barney Frank said prohibiting the trades was “on the table” in new financial regulatory legislation. A draft bill released in October was watered down to give regulators authority to prohibit so-called abusive swaps, or any swap “that would be detrimental to the stability of a financial market or of participants in the financial market.”

That provision was later erased, with Frank explaining “there was concern that a broad grant to ban abusive swaps would be unsettling.”

Swaps Volume Small

If credit-default swaps traders fueled the sell-off in Greek bonds, they did it by wagering an amount that’s about 3 percent of the government’s total debt, data compiled by Bloomberg show.

Credit-default swaps tied to a net $9 billion of Greek debt were outstanding as of March 5, according to the New York-based Depository Trust & Clearing Corp., which runs a central registry that captures the majority of trading in the market. That compares with about $271 billion of Greek debt, International Monetary Fund data show.

There were swaps on a net $109 billion of 10 European nations, including Portugal, Spain, Italy and Ireland, less than 1 percent of the countries’ combined debt.

Contradicting claims that derivatives trading exacerbated the Greek debt crisis, German financial regulator BaFin said on March 8 that market data didn’t show evidence that credit- default swaps were used to speculate against Greek bonds. Data provided by the Depository Trust didn’t indicate “massive speculative action,” BaFin said.

‘Throwing Some Fog’

“Politicians are blaming speculators even though there’s no fundamental data to support it,” European School of Management’s Hagen said. “At the moment, Merkel and Sarkozy are throwing some fog and trying to deviate attention from the underlying issue, which is Greece’s deficit.”

Germany’s Association of German Banks, which represents more than 220 private commercial banks including Deutsche Bank AG and Commerzbank AG, defended credit-default swaps as “an important instrument for the financial markets, e.g. for hedging purposes.”

“At the same time we agree that the market needs more transparency,” the association said in a statement on March 9.

German banks had foreign claims of $43.2 billion related to Greece on Sept. 30, behind France and Switzerland, according to data from the Bank for International Settlements in Basel, Switzerland.

Credit-default swaps are an important market indicator for the health of a country or company, and so-called speculators helped bring Greece’s debt problems to politicians’ attention, forcing them to get their deficit under control, said Hans-Peter Burghof, professor of banking and financial services at the University of Hohenheim in Stuttgart, Germany. After the Greek government announced a reasonable budget plan, the speculation stopped, he said.

“You shouldn’t kill the messenger,” Burghof said.

Greek Deficits

Greece posted a budget deficit of 12.7 percent of gross domestic product in 2009, more than four times the EU’s 3 percent limit, raising concerns it may be unable to repay its debt. Investors have become less skittish after Greece announced 4.8 billion euros ($6.6 billion) of additional budget cuts and sold 5 billion euros of bonds last week.

The risk premium investors demand to buy Greek 10-year debt over comparable German bonds, the European benchmark, fell 4 basis points to 309 basis points yesterday. That is down from a high of 396 basis points on Jan. 28, though still more than twice the level at the start of November. Spreads on Spanish and Portuguese bonds have also widened.

Soros, Munger

This isn’t the first time regulators have blamed credit- default-swaps traders for exacerbating market declines. New York Attorney General Andrew Cuomo started an investigation in September 2008 into whether trading in the swaps was manipulated to spread rumors about financial firms and drive down stock prices amid the credit crisis that led to the collapse of Lehman Brothers.

Richard Bamberger, a spokesman for Cuomo, didn’t respond to a request for comment on the status of the investigation.

Others in the U.S. including hedge-fund billionaire George Soros have called for greater transparency and limits on trading naked swaps. Charles Munger, vice chairman of Berkshire Hathaway Inc. in Omaha, Nebraska, wants an outright ban on trading. Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission, repeated calls this week to give regulators the authority to police the market for “fraud, manipulation and other abuses.”

Brevan Howard

Hedge-fund firms betting on a Greek default would have lost 8.8 percent in February, according to CMA Datavision pricing on Bloomberg. Some funds that made money on the trade placed those bets years ago.

Brevan Howard Asset Management LLP, Europe’s largest hedge- fund firm, and Louis Bacon’s Moore Capital Management LP, are among hedge funds that have told investors they’re not betting against Greece or its CDS.

“The short trade in these credits is extended, crowded, fully prices the fundamentals and is exposed to a regulatory squeeze,” Brevan Howard said in an investor letter last month.

German and French banks may have the most at risk in Greece, Portugal and Spain, adding to pressure on Merkel and Sarkozy to take action. German banks had foreign claims of $330.8 billion and French lenders $306.8 billion related to the three countries on Sept. 30, according to the Bank for International Settlements. That compares with $156.3 billion at U.K. lenders, the data show.

“Greece is the first line of defense, and Berlin and Paris want to send a warning signal to speculators to stop the crisis from spreading to bigger countries such as Spain,” Burghof, the University of Hohenheim professor, said.

‘Not as Pressing’

Greece’s troubles don’t resonate the same way in the U.S., said Raj Date, executive director of the Cambridge Winter Center for Financial Institutions Policy in New York.

“For the Europeans, there are a lot of here-and-now issues with respect to Greece which are not as pressing for American policy makers,” Date said.

The world’s five biggest CDS dealers are JPMorgan Chase & Co., Goldman Sachs Group Inc., Morgan Stanley, Deutsche Bank and Barclays Plc, according to a report by Deutsche Bank Research, citing the European Central Bank and filings by the U.S. Securities & Exchange Commission. The measurement is in terms of CDS notional amounts bought and sold.

Still, Germany’s Merkel has signaled that Europe would go ahead alone with a ban on naked swaps even while acknowledging that a similar move in the U.S. is needed.

“We know that this also has to happen in the American area, because Europe is one thing and America is another, but we think that a first step here in the European Union would be helpful,” Merkel said in Luxembourg on March 9.

To contact the reporters on this story: Ben Moshinsky in Brussels at bmoshinsky@bloomberg.net; Aaron Kirchfeld in Frankfurt at akirchfeld@bloomberg.net